The British Pound's Little-Known Crisis of 2015

Jan 7, 2013
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Posted by: Ben Traynor

It may be only a matter of weeks before the Pound's next great decline begins...

Right AT the top of the banking pyramid you have an institution called the Bank for International Settlements (BIS), writes Paul Tustain – founder and director of BullionVault. It acts like a central bank for central banks.

Germany can draw down currency from the Bank of England and deposit it into the BIS. Again, it just writes the cheque drawn on the importer's central bank, and pays it into its BIS account. You could say Germany has placed its 'Foreign Currency Reserve' at the BIS.

The BIS does lots of things I don't understand. But I am starting to understand the Special Drawing Right (SDR). It's a sort of 'compost' currency worth – at the moment – about the same as a Pound. You can mix it up yourself in the garden – as a heap of slowly rotting currencies in the following proportions: US Dollars (0.66) Euros (0.42) Yen (12) and Pounds (0.11). The package gets acquired by exporters when they flip all sorts of other accumulated foreign currency.

The BIS's Special Drawing Right allows countries acquiring – say – too many Rupees (that would be exporters to India, like Thailand, who don't want to accumulate the ever inflating Indian Rupee) to flip out of Rupees into this super-solid mixture of 'top' currencies, packaged as an SDR. But the Rupee not being in the SDR the BIS looks to dispose of it. So the Rupee stays low, which in principle makes it easier for India to export.

Our careful analysis shows that the SDR composition allows the UK and US to be lazy, and everyone else to turn a blind eye. Few British or American workers have any intention of doing anything cheaper than a Thai factory worker, so their negative balances have in the meantime been parked with the Thais – within SDRs – as a store of wealth. The Thais are assuming that this makes a good solid base for Thailand's own 'Foreign Currency Reserve'.

For as long as everyone else is buying Pounds as part of a package labelled SDRs (or indeed in their own right) this allows the British to run a big trade deficit for a very, very long time. Lots of the outstanding calls on the British to get off their collective ass are frozen into those SDRs and held by the rest of the world as a trusted store of value.

The Pound is by a long way the most overweight currency in the SDR, being 11% of its value but less than 3% of the world economy. It's an enormous current privilege for us British.The world's financial garden mulch could be legitimately advertised "Now with extra British Pounds!"

I doubt this will turn out well, either for us, or – frankly – for the Thais.

In a way, I suppose, it seems that all global trade is always balanced, by the definition of trade. But whereas we have an appetite for American grain, Japanese digital cameras, European fridges and cars, and absolutely anything from China, their manufacturers seem to have an appetite for the security of a store of value that they can in future draw down from us. They don't want our products, they appear to want some savings denominated in our money, which is extra-ordinarily convenient for British shoppers.

Somehow the British got to this situation of being a key component of the SDR. But as a component – and from the point of view of the user of SDRs – you'd have to say the Pound is now spectacularly unfit for the purpose.

A bit of thinking about how the SDR is composed, and what it is for, shows that the SDR can be a stabilising force in world trade when it works to distribute the currency of strong exporters as a reserve for everyone else. If that is how it is composed it will force exporters' currencies up, make their exports more expensive, and generally retain value for the people who hold it.

This is exactly how the SDR works with Japan, who are exporters, but who find the inclusion of the Yen into SDRs causes their currency to be held artificially high and suppresses their prodigious export power. In the case of Japan the SDR acts as a force for bringing world trade back toward balance.

The inclusion of the Pound, a long time ago, was at a time when the British economy may have merited its inclusion (I really don't know) and, this inclusion being decided by committee, and in the absence of a crisis, it remains the status quo today. But it has helped hold our currency high making it still harder for us to export – even though we run a large trade deficit. It encourages us to enjoy cheap imports, and works to increase the imbalance in world trade in goods.

It has also caused SDR holders to hold a chunk of Pounds which they might reasonably see as overvalued, which ought to matter to people like the Thais, and the Chinese, because the whole point of the SDR for them is to store reserves of international purchasing power.

As it happens the recipe for the SDR is re-set periodically. The next re-setting is due in January 2015. Since the last re-set the Chinese have become the world's biggest exporters, and exporting countries are looking for a secure store of value. They have been accommodated by ownership of SDRs – and lots of Sterling held directly too.

As a Brit I really don't like looking at the way this could play out. Why would all the voters on the IMF and BIS committees continue to support the Pound being overweight in the composition of the SDR? Why would the Chinese seek an SDR that incorporates Sterling? What would happen if there were a move to make an overdue and substantial reduction in the British weighting or – even – to replace it with Chinese Renminbi.

When push comes to shove, if the Americans and the Chinese are arguing over Chinese suppression of their exchange rate, and the Chinese are offering the Renminbi as a replacement for Sterling within the SDR, would the British deserve or get any support from America, or anywhere? No, they would not. The Americans want a more expensive Renminbi, the Chinese want a bigger slice of the international monetary action for the Renminbi, and the Europeans (the other big voting bloc, and a major SDR component) could be absolutely relied upon to support the Pound's marginalisation and a few British financial chickens coming home to roost. In the Eurozone they are starting to understand that this is what financial chickens generally do.

It looks possible that the case everyone will rightly make is that the SDR should be composed of the currencies of strong exporters – because this both secures the SDR as a meaningful Foreign Currency Reserve, and helps to bring world trade into balance. The Pound – I believe – could soon be isolated, marginalised, and eventually ejected from the SDR's composition, leading to a big surplus of ex-SDR pounds being available on international currency markets. I don't think there will be many takers.

So, with all the usual provisos about the danger of making predictions, I say that UK savers should be ready for an escalation in the cost of your favourite imports, starting soon, and expect it to accelerate as the market prepares for January 2015. It may be only a matter of weeks before Chinese positioning for a seat at the top financial table spells a turbulent near term future for the Pound.

Ben Traynor

Ben Traynor is a Cambridge economics graduate and professional writer with a specialist interest in monetary economics. Ben also serves as editor of Gold News, the analysis and investment research site from gold ownership service BullionVault.